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About six in 10 audits are Discriminate Information Function Audits (DIFs) arising from a high score in the Discriminant Index Function, a “secret” format under which all returns are scored.  Returns with the highest scores are then screened by a “classifier” to determine the likelihood of inaccuracies, particularly those with significant revenue potential.  Below are some audit hints based on data from the 2010 tax reporting year.

Non-Business Taxpayers

• Highest Audit Areas
  • Earned income credit (involved in 30 percent of 2010 audits)
  • Charitable contributions disproportionate to income
  • Employee business expenses
  • Foreign bank accounts (including FBAR filing)
  • Suspicious stated basis

• Other Audit-Triggering Items
  • Little or no gratuity income for tipped workers
  • Dependency allowance beyond immediate family
  • Conflicting dependency allowances/itemized deductions
  • High medical expenses
  • Casualty losses
  • Deductions greater than on information returns
  • High itemized deductions relative to income
  • High rental losses (especially by real estate professionals)
  • Claiming material participation in loss activities (especially where there is high W-2 income)
  • Bad debts
  • Obvious participation in scams

Business Taxpayers

• Highest Audit Areas
  • Cash deposits in excess of $10,000
  • Schedule C Losses especially on modest gross income (may be avenue to deduct “employee business expenses”)
  • Large flow through entity losses (basis issues)
  • Office in home deduction
  • Disproportionate travel, meals and entertainment
  • Large “miscellaneous” or “other” Expenses

• Other Audit-Triggering Items
  • High automobile expense in businesses not typically requiring autos
  • Obviously inaccurate depreciation
  • Bad debts of cash basis taxpayers
  • Margins outside of industry norm
  • Unusually high line items

What Are Other Causes of Audits?

• Specific industry targets (Market Segment Specialization Program – MSSP)
• Related party audits
• Disgruntled “tipsters”
• Targeted preparers (EIC, charitable, employee business expenses)
• National Research Program

Percentage of Returns Examined in Fiscal 2010

• 1.1% of all individual returns but 8.4% of those with positive income > $1 M
• 1.4% of ‘C’ corporations
• 0.4% of ‘S’ Corporations and partnerships
• 0.7% of Gift tax returns
• 10% of Estate tax returns

Types of Examinations in Fiscal 2010

• Correspondence    78%
• Office and field     22%

The “Tax Gap”

Taxpayers are believed to report about 87 percent of their proper taxable income with 71 percent of the “gap” constituting unreported income and 29 percent constituting overstated deductions.

• Only 43% of small business Schedule C receipts are unreported
• Only 28% of small farmers’ Schedule C receipts are reported
• Only 19% of cash businesses’ receipts are reported

 

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